Credit, scorecards, risk ratings!!! What does this have to do with RedArc? One of our clients is working on a project that involves determining how risk is measured. We have been doing this for years, now it is time to get it on record, so we will start with the basics of credit.

Millions of business rely on Credit to allow them to grow beyond the initial capital they were able to obtain.

Lending groups need to anticipate and understand the loss that may be incurred if there is a default by the borrower. This is known as Expected Loss (EL).

They key variable in the EL formula is the probability of default (PD). If the probability was zero then there would be no need to consider loss. However if there is even a 1% chance of loss a lender will generate an expected loss for every loan.

Time factor is implied in this formula.

In simple terms describing the expected loss (EL) can be summarized as the total amount loaned (EAD), factor the amount of collateral that secures the loan (LGD) and finally factor the likelihood that the borrower will default (PD).

The expected loss formula is expressed as EL = PD * LGD * EAD

Starting from right to left of our formula helps set the 2 variables that are related to the amount of the loan and how much is secured.

EAD
The total exposure that the borrower can present is the amount owed at the time of the default. this is EAD, exposure at default. This is generally not bigger than the credit facility made available to the borrower.

LGD
The loss given default (LGD) is a fraction of the EAD which is not covered by collateral. For example if 30% of the EAD is secured by collateral that the bank can liquidate, then the LGD is the remaining portion of 70%. The percentage of the EAD that can be recovered is the Recovery Rate (RR). Thus LGD can be calculated with the following: LGD = 1 – RR. using our previous example. .70 = 1 – .30

PD
The PD, probability of default is the likelyhood the loan will no be repaid. it is calculated for each borrower and there is no “number or formula” that can be plugged in that would satisfy each lending groups own portfolio. PD is rated in percentage from 0% – 100%. The lower the number the less risky, or less probable. common calculations to determine this is the credit history and nature of the investment. Moody’s and S&P can provide PD for certain types of borrowers, however lenders often generate their own scoring models to make PD more accurate.

http://riskarticles.com/expected-loss-el-calculation/